The Federal Reserve Act officially states that the US Fed has a has a dual mandate of protecting growth and stable prices. However, over the last few months, the actions of the current Federal Reserve board imply that that there is just one mandate of protecting growth through "moderate long term interest rates", even as they turn blind eye towards its other mandate…namely Inflation.

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

There has been sharp deterioration in the in the Economic conditions in 2008 so far, with almost all the major parts of the US Economy showing that they are in negative territory. US ISM Manufacturing and Services indices are below their “boom bust” level of 50.0 and the US jobs addition has shown negative growth for the last 2 months. Add to that, much of the recent inflation increases with the Y/Y headline CPI at 4.0% for Feb-08 and the Core PCE for Jan-08 at 2.2%, above Fed’s comfort zone.

While most would like to remember last Friday for what happened with Bear Stearns, we would disagree as even more sobering was Ben Bernanke speech on "Fostering Sustainable Homeownership" at the National Community Reinvestment Coalition Annual Meeting, Washington, D.C. That speech confirmed what has been the fear of many economists, that it is not just sub-prime which is the problematic area for the US housing market. The prime, near prime or government-backed mortgages is equally to blame.

The current high rate of delinquencies and foreclosures is not confined to the sub prime market. [U]In 2007, about 45 percent of foreclosures were on prime, near-prime, or government-backed mortgages.[/U] Across market segments, delinquencies are rising fastest on the more-complex loans originated over the past few years.

Now since there is a confirmation from the authorities to be, that prime housing market is also in such pain, it is very likely that a combination of further contraction in economy is to follow by falling consumption in households. As such, further rate cuts are likely to follow, with an expected 100 basis points this meeting itself to foster a contracting economy and revive it in the second half of the year, when the combined effects of lower rates and fiscal stimulus package kick in.

For Inflation hawks, the some of the Fed officials has been maintaining that there could be "Rapid Reversal" in the rate cuts when the economic situations revive. However, with the deepening of the credit crisis, housing contraction and falling job markets, even that word could be dropped as falling demand could catch up with commodities. This process could have already started yesterday. However, the thing to note is that falling commodities are not sure, as Supply side issues need to be looked at.

A rate cut of less than 100 basis points is likely to be greeted with lots of negative sentiment and would be negative for carry-trades and Equity markets. A 100 basis points rate cut on the Fed Funds rate to 2.0% (if seen) would take it below the Fed’s preferred inflation indicator…...Namely "Core PCE price index" which was last reported at 2.2%. This means that the Real interest rates would turn negative for the first time since 2003. A negative real rate scenario is generally very negative for $-Yen. The discount rate, which was cut on Sunday, is again likely to cut, in the same magnitude to the Fed Funds rate. The chart of Fed’s rate cycle since 2000 is given below.

Over the past 2 months, the importance of the European central bank meetings have dwindled slightly, which is not surprising as it normally happens when a central bank is on hold in its interest rate cycle. The ECB has been on hold at 4.00% from June-2007 and there has been no chance in ECB stance as well.

However, in the last few days ever since Euro has moved above 1.5000 against the USD, there has been a marked increase in ECB rhetoric, to voice concern about a very strong Euro and the negative consequences thereof on the European economy. For instance, on Tuesday Belgian Finance Minister Didier Reynders said that "What I wish is that we will see the U.S. authorities' attitude strengthening" (in favor of a stronger dollar). Further EU'S Barroso said, "It is likely that the ECB will examine the strong Euro attentively".

In light of this, today’s press conference of Trichet would be focusing on two important things, which are in a way interlinked…European interest rates and Euro market level. The link is that ECB’s reluctance to cut rates (in fear of inflation), at a time when US is on a cutting cycle is fueling Euro gains against the USD. Realistically the recent EU fundamental data shows that the economy is moderating gradually (a soft landing) and hence there is no reasons to justify a rate cut at a time when Inflation is at its 8 year high.

Any rhetoric from Trichet on Euro level is likely to be very important. Trichet usually terms FX moves as "Brutal" if he finds any move stretched.

Apart from Trichet’s speech, the ECB staff would also give new projections for growth and inflation for the next 2 years, which is likely to get plenty of attention. The growth outlook is widely expected to be revised down and the inflation forecast is likely to be revised up. The previous ECB staff projection for 2008 GDP is 1.5% - 2.5% and the Inflation forecast is 2.0% - 3.0%.

OTTAWA – The Bank of Canada today announced that it is lowering its target for the overnight rate by one-half of one percentage point to 3 1/2 per cent. The operating band for the overnight rate is correspondingly lowered, and the Bank Rate is now 3 3/4 per cent.

Information received since the January Monetary Policy Report Update (MPRU) indicates that economic growth in Canada through the four quarters of 2007 was broadly in line with expectations. Domestic demand has remained buoyant, as rising commodity prices and high employment have continued to support income growth. Canada's net exports weakened further in the fourth quarter, reflecting the slowing U.S. economy and the impact of the past appreciation of the Canadian dollar. Overall, the Canadian economy remained above its production capacity at year-end. Core and total CPI inflation – at 1.4 per cent and 2.2 per cent, respectively, in January – have also been consistent with the Bank's expectations.

At the same time, there are clear signs that the U.S. economy is likely to experience a deeper and more prolonged slowdown than had been projected in January. This stems from further weakening in the residential housing market, which is adversely affecting other sectors of the U.S. economy and contributing to further tightening in credit conditions. The deterioration in economic and financial conditions in the United States can be expected to have significant spillover effects on the global economy. These developments suggest that important downside risks to Canada's economic outlook that were identified in the MPRU are materializing and, in some respects, intensifying.

The Bank now judges that the balance of risks around its January projection for inflation has clearly shifted to the downside, and, as a result, the Bank is lowering the target for the overnight rate. Further monetary stimulus is likely to be required in the near term to keep aggregate supply and demand in balance and to achieve the 2 per cent inflation target over the medium term.

The Bank will publish a new projection for the economy and inflation, including risks to the projection, in the Monetary Policy Report on 24 April 2008.

Trade Wise, Trade Well!

FX Thoughts - Bank Of Canada Could Deliver A Large Rate Cut04-Mar-20080945 IST or 0415 GMT or 2315 EST

After the RBA hiked rates earlier today, the second big central bank meeting for the day is of Bank of Canada, which in contrast is likely to deliver its third successive rate cut of 25bps in as many meetings. A cut of 50bps could also be seen and would not be entirely surprising. The Bank of Canada has been so far been most aggressive following the US Fed and the main problem it is facing is from a Contagion effect from a possible Recession across the border in US and the resultant slowdown in Canada. The Q4 2007 annualized GDP yesterday came in at 0.8% against 3.0% in Q3, already showing the effects of a US slowdown on Canadian Economy.

The broad reasons for the BOC rate cut remains the same…

1) Fed Effect2) Falling Inflation

1) Fed Effect: The US Fed has cut rates by 225 bps since Sep-2007 and is very likely to cut once again by 50 bps in two weeks time. The Bank of Canada has so far most aggressively following the Fed and is likely to do so in the near future as well. If there were a difference in monetary policy between the two neighbours, then the CAD would appreciate which would be very bad for the manufacturing base of Canada. Thus the Bank of Canada is being forced to follow the interest rate path of US Fed.

2) Falling Inflation: Much unlike its bigger neighbour, the United State where Inflation has been the biggest working factor which is acting as a deterrent for rate cuts, there is no such problems for Bank of Canada. Infact the Bank of Canada Core Inflation Index for January-08 was 1.4%, at its 30-Month low. This compares with the top of BOC inflation comfort zone of 2.0%.

The primary cause of the fall in Canadian inflation has been the strength of the Canadian Dollar seen last year, and also high base effect from 2007.

While the rate cut of 25 bps by BOC is already discounted in the market, any larger cut is likely to negatively impact the CAD. Nevertheless, the statement from BOC accompanying the rate cut would be important. Indications of further rate cuts would keep the CAD pressurized against fellow currency AUD, which is in a rate hiking cycle in the next few days/weeks. Other than that, a larger cut (of >25bps) would also negative for the CAD against USD atleast in the short term. There could be some changes in the statement as this is the first monetary policy meeting for the new BOC governor, Mark Carney.

Technical View on USD-CAD:

After the sharp fall in the early part of last week, USD-CAD had a recovery on Friday, which has continued so far. However, still the larger trend of USD-CAD remains bearish and therefore the pair could top around, possibly near 1.0020 to fall again. Above that the Resistance would come in at 1.0100. On the downside the immediate Support would come in at 0.9820 and then at 0.9710. The bias for USD-CAD remains bearish in the longer term and selling rally would be recommended.

The Reserve Bank of Australia has hiked rates by 25 bps 7.25%, and has issued a statement which is relatively hawkish. This could continue to support the Aussie Dollar in the near term. However, the rate hikes from 2007 has been termed as "Substantial", no hike is seen next month.

The statement is given below.

From RBA Statement

At its meeting today, the Board decided to increase the cash rate by 25 basis points to 7.25 per cent, effective 5 March 2008.

This adjustment was made in order to contain and reduce inflation over the medium term. Inflation was high in 2007, with an annual CPI increase of 3 per cent in the December quarter and underlying measures around 3½ per cent. Domestic demand grew at rates appreciably higher than the growth of the economy’s productive capacity over the year. Labour market conditions remained strong into early 2008 and reports of high capacity usage and shortages of suitable labour persist. Inflation is likely to remain relatively high in the short term, and will probably rise further in year‑ended terms, before moderating next year in response to slower growth in demand.

The Board took account of events abroad and developments in financial markets. The world economy is slowing and it appears likely that global growth will be below trend in 2008. Recent trends in world commodity markets, however, have further strengthened prospects for Australia’s terms of trade.

Sentiment in global financial markets remains fragile. Australian financial intermediaries are experiencing increases in funding costs, which are being passed on to customers. Some tightening in credit standards for more risky borrowers is occurring.

There is tentative evidence that some moderation in household demand is beginning to occur, with business and consumer sentiment softer recently, and household credit demand slowing somewhat. The extent of that moderation is uncertain, however. As the Board noted last month, a significant slowing in demand from its pace of last year is likely to be necessary to reduce inflation over time.

Having weighed both the international and domestic information available, the Board concluded that a further tightening in monetary policy was needed to secure an inflation rate of 2‑3 per cent over time. As a result of this and earlier actions, and rises in borrowing costs which are occurring independently of changes in the cash rate, the overall tightening in financial conditions since the middle of 2007 is substantial. The Board will continue to evaluate prospects for economic activity and inflation in the light of new information.